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July 2, 2013

Midstream MLP Funds Fraught With Opportunity, Tax Danger

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Oppenheimer SteelPath’s Brian Watson likes to note that in 2012, the United States saw the greatest increase in domestic crude production ever, which AdvisorOne named as one of the most underreported facts of last year. Even better, Watson, director of research and portfolio manager at the firm, added that 2013 is on track to be even better.

Although it was overlooked by the public at large, other investors, particularly those in the master limited partnership “midstream” space, are jumping all over it. Directional flows are being reversed, the country is on its way to achieving energy independence and net exporter status, and there seems to be a bottleneck in — you guessed it — the midstream space.

Marc Friedman, director of research at Princeton Fund Advisors, the co-advisor of the Eagle MLP Strategy Fund, certainly agrees with Watson’s assessment, and notes an important example.

“The Bakken shale field up in North Dakota did about 150,000 barrels per day in the mid-1980s,” Friedman explains. “It declined through the early 2000’s to less than 100,000 barrels per day. At the end of 2011, they were doing over 400,000 barrels per day. Currently, there doing about 750,000 barrels per day.”

The exponential increase isn’t limited to oil, of course, and similar increases are happening in natural gas production in places like the Marcellus shale field in Pennsylvania and "really all over the country.”

All over the country means plenty of opportunity, which is translating to strong performance. MLPs, as measured by the Alerian MLP Index, had a 16.4% annualized return from June 2006 through March 2013. This compares with a 5.6% return for the S&P 500 over the same period. MLPs yielded 5.7% compared with 2.1% for the S&P 500.

Historically, midstream and infrastructure MLPs have been difficult to access for the retail investor, one of the reasons Eagle MLP Strategy Fund and similar '40 Act funds are now available.

Which sounds great, but with so many rushing to fill the space, why Eagle? Friedman says Princeton, the research side of the business, is one advantage.

“We create asset allocation models, we do manager search selection, we perform the due diligence,” he says. “From that expertise on that side of our business, we see asset classes and managers that we either like or there’s no liquid product like what they’re doing. So we approached Eagle, asked them if they would like to subadvise the fund for us and they said yes.”

Another reason is that, unsurprisingly, Freidman doesn’t like the other mutual funds out there.

“They’re taxed in a way that makes them difficult to outperform the index,” he states. “The IRS regulation for mutual funds states that if you invest more than 25% of your fund in MLPs, it gets taxed as C-Corp., which leads to significant underperformance. Where most mutual funds aren’t taxed, this one would be. We limit our fund to 25% in MLPs that issue K-1s; the rest of the investments are in what we consider midstream MLPs that issue 1099s. By doing so we avoid that situation; we’re in a lower tax bracket, you could say. Avoiding that 'tax drag' is a major differentiator.”